The Spring 2016 issue of The Journal of Retirement features articles that cover a wide range of issues in retirement security. Two articles deal with the thorny issue of financial illiteracy and how it can affect some of the key decisions that employees or personal investors need to make. Another article addresses the recent history and current travails of corporate pension plans. Two articles address annuities: the lead article deals with the role that longevity (long deferred) annuities might play in enhancing retirement security, and the other deals with the fiduciary issues that arise when a retirement plan provider chooses an annuity for its plan members. The Spring 2016 issue also includes an article on the retirement preparedness of small business owners, and an article that explains survivor benefits of Social Security and when to claim them. The background of the authors is as varied as the subjects they address. They include practicing attorneys, Wall Street analysts, academic economists and jurists, and government officials. This diversity is testimony to the multidisciplinary approach that the study of retirement security demands and that The Journal of Retirement strives to foster.
The decline of the defined benefit plan (analyzed in the article in this issue by Martin Leibowitz and Antti Ilmanen) and the dominant role now played by 401(k) and other defined contribution (DC) plans has undoubtedly shifted investment risk from plan providers to plan participants. However, DC participants face another very important risk, one that may not have commanded all the attention it should have: the risk that the savings accumulated at retirement may not last through the rest of the retiree’s life. Longevity risk is a major problem. Although economists have long extolled the virtues of immediate life annuities as a form of longevity insurance, these instruments have never proved popular with Americans. In “The Market for Longevity Annuities,” Katherine Abraham and Ben Harris provide a comprehensive survey of the economics of longevity annuities, a version of the immediate annuity that may well prove to be more popular, and the regulatory and administrative issues these novel instruments raise.
In the case of longevity annuities, unlike an immediate annuity, payments from the insurance company begin only many years after the contract is signed. Payments are made for a shorter period, and the delay in their start date and the much greater probability that the annuitant dies before receiving many payments mean that they are heavily discounted. The authors compare an immediate annuity bought by a 60-year-old male with a longevity annuity bought by the same person with payments starting only at age 80. The immediate annuity is estimated to pay about $535 per month, while the longevity annuity pays about $2,540 per month, almost five times as much. A longevity annuity can thus provide much more “tail” insurance than an immediate annuity.
The authors survey the arguments that economists have advanced to explain why longevity annuities are superior to immediate annuities. This superiority is particularly evident when the share of a retiree’s wealth that will be devoted to annuity purchase is not large. They then turn to address the key question of why the market for these innovative instruments remains so small. They analyze three different barriers to the growth of the market: the behavioral biases of consumers and the biases of financial advisors; regulatory and other barriers impeding plan sponsors from offering these and other lifetime income products; and the inability of insurance companies to insure against longevity risk. To give the flavor of this discussion, longevity annuities, like immediate annuities, may be viewed by consumers as an investment product, and not as an insurance product, and thus compare unfavorably with other investments. Concerns over the financial viability of insurance companies, although not necessarily a sign of bias, are also a factor. Plan sponsors may be inhibited by a safe harbor provision that the authors think is unnecessarily demanding. The lack of good hedges (e.g., longevity bonds) can discourage insurance companies from underwriting annuities.
The authors propose a comprehensive set of measures to dismantle these roadblocks. Consumer hesitancy might be addressed by government guidelines to promote wise financial decisions. The government could issue a financial graphic (as was discussed in the article by William Gale and Ben Harris in the Fall 2013 issue of the JOR). Insurance companies might also be allowed to mention the state guarantee programs that exist to compensate policyholders for insurance company failure; at present nearly all states forbid such mention. Another measure that might increase the popularity of longevity annuities is to include them in the range of options offered by the Thrift Savings Plan, which is the country’s largest DC plan. Plan providers’ enthusiasm for offering longevity annuities to plan participants could be enhanced by reforming the safe harbor provision to make it a more transparent and easily verifiable test of the financial soundness of insurance companies. Finally, better risk-management options could be developed for the insurance companies that must bear longevity risk. These are but a few of the proposals the authors make in this authoritative article, which could well become a standard reference in discussions and analyses of longevity annuities.
In “Regulatory Recommendations for the Department of Labor to Facilitate DC Lifetime Income,” Bob Toth and Evan Giller zero in on one of the factors inhibiting the development of a market for longevity annuities (and annuities more generally), which is also raised by Abraham and Harris: concerns by plan fiduciaries than even the exercise of due diligence will not reduce their exposure to liability. ERISA requires plan fiduciaries considering the incorporation of an annuity in their plan to develop and implement a prudent procedure for selecting an annuity provider. The authors’ experience tells them that the typical plan fiduciary is ill-equipped to vet the financial soundness of an insurance company and to choose knowledgeably among different types of annuities. The aim of their article is to make recommendations that will make their fiduciary obligations less onerous. To this end they propose that the DOL and the Treasury combine to develop and host a website that will be a clearinghouse for the information on annuity providers and products that plan fiduciaries need. The safe harbor provisions for fiduciaries choosing an annuity provider (the Safest Available Annuity Safe Harbor regulation) require some formal guidance to clarify the Employment Benefits Security Administration’s view of the law. This should increase the comfort level of fiduciaries as they choose an annuity provider. The authors believe that the current regulatory framework is essentially sound, although in need of interpretative guidance. As an example of constructive interpretation, they refer to a recent field assistance bulletin limiting fiduciary liability for the imprudent selection of an annuity product to six years following the date of the contract.
The decline in the labor force coverage of the traditional (defined benefit) pension plan since the 1980s has been extensively analyzed. The surviving plans often have been closed to new employees, or even to established members, who can no longer contribute to the plan. In addition, many plans are now cash balance plans, which are legally DB plans but with the attributes of a DC plan. Those plans that remain typically invest a smaller share of their assets in equities than they used to.
In “U.S. Corporate DB Pension Plans—Today’s Challenges,” Martin Leibowitz and Antti Ilmanen succinctly analyze the reasons for the traditional plan’s fall from grace, before turning to address an important issue that contemporary plans face—how to de-risk the plan, that is, achieve a comfortably high and stable funding ratio (the ratio of assets to liabilities). Today’s plans can find themselves in a situation the authors describe as overweight in equities and underweight in duration. A stable funding ratio requires that a duration mismatch between a plan’s liabilities and its assets be minimized. In practice, this means increasing the share of bonds in the portfolio. However, the average rate of return to equities is higher than that of bonds, so moving out of equities into bonds can require additional contributions to achieve the increase in the funding ratio. An underfunded plan can allocate a high share of its assets to equities in the hope that a bull market can bail it out. Unfortunately, this strategy can also result in the plan’s going further in the hole. The use of options can mitigate this particular risk and help to maintain a stable funding ratio.
The authors find that a strategy of derisking—moving from stocks to bonds—is more likely for plans with funding ratios near 100. The belief that interest rates can only go up makes being underweight in bonds (a duration underweight) more attractive than it would otherwise be. Many plans have committed themselves to a strategy of increasing the share of bonds as the funding ratio increases, perhaps because as the ratio increases, the perceived need to gamble on a bull market recedes. Finally, the authors address the modalities of buyouts and make the telling point that because of the difference in discount rates used by the plan and the insurance company that will assume the pension liabilities, the funding ratio may have to exceed 100% quite substantially.
One of the more important decisions a pension plan member takes is whether to roll over her plan into an IRA. The decision is a complicated one, in which a number of features of the plan and the IRA need to be carefully compared. Perhaps the most important of these are the fees the plan and IRA charge, as well as the range of investment options each can offer. In “Financial Illiteracy Meets Conflicted Advice: The Case of Thrift Savings Plan Rollovers,” John Turner, Bruce Klein, and Norman Stein study the behavior of rollovers from the Thrift Savings Plan (TSP) for federal government employees. The TSP is known for its extremely low fees, which partly result from the huge size of the plan: It is the biggest in the United States. The TSP does not offer its participants a huge number of investment funds, but it does offer enough to satisfy a broad range of preferences for the tradeoff between risk and reward. These features mean that a prima facie argument exists that for most TSP participants, a rollover to an IRA is not a good idea. Nonetheless, some 45% of government employees who separated in 2012 had withdrawn all their funds by end-2013. In 2012, transfers of the full account balance to an IRA or another plan accounted for 65% of monies withdrawn from the TSP. Assuming no difference in rates of return and an average fee for IRAs of 74 basis points (compared with 3 basis points for the TSP), the authors calculate that rollovers into an IRA would cost former TSP participants about $1,000 per year.
The authors recognize a rollover can be a good idea in certain circumstances, but they conclude that a complete rollover from the TSP is rarely good advice. The benefits from the increased diversification an IRA offers are considered small.
The authors scrutinize the advice that TSP participants receive concerning rollovers. The websites they consulted do not recognize the fee differential between the TSP and IRAs. A telephone survey of IRA providers found that only one advised against a rollover. An email survey of personal financial advisors, who are subject to a higher fiduciary standard, found less enthusiasm for rollovers but still more than the authors thought was warranted. The authors argue that a recommendation to roll over funds may reflect the advisor’s ignorance of the low fees the TSA charges. However, their clients may simply not be aware they are getting bad advice. The article goes on to review the regulatory framework, arguing that it is not adequate to protect pension participants from seriously bad advice.
Financial literacy is often gauged by the results of a simple questionnaire that tests knowledge of interest rates, inflation, and other financial basics. The authors suggest that a knowledge of the fees their plan charges is also an important aspect of financial literacy. The evidence of their article suggests that many IRA holders are unaware of the fees they pay.
For reasons this letter has already touched on, the ability to make sound financial decisions is more important than ever. A decision to participate and maintain participation in a retirement savings plan, and to make adequately sized contributions to it, is critical for a financially secure retirement. Many employers sponsoring a retirement plan have sponsored financial education programs of one kind or another to help their employees make sound financial decisions. Nonetheless, how effective these programs are has been uncertain.
In “Addressing the Retirement Savings Crisis in the United States: The Role of Employer-Provided Financial Education,” Barbara Smith reviews the findings of nine studies of the impact of employer-provided education. These studies each follow one of three different approaches: subjective self-assessments by program participants, econometric studies, and randomized control trials. The studies she surveys sought to determine if the programs, usually seminars, actually changed behavior. She finds solid evidence that they did; for example, participants were more likely to become participants in an employer-provided plan, and their monthly contributions increased. Her article explains why randomized control trials are the best way to determine the effectiveness of financial education programs. In particular, they avoid the problems of self-selection bias and self-reporting bias. Among the studies’ findings, the impact on behavior tended to be greatest among participants with modest incomes and young participants. Studies that provided participants with brochures that explained the link between more contributions to plans and increased income or savings in retirement were quite effective. The seminar was an effective communications tool, and personal counseling was also effective. The author suggests that the apparently greater effectiveness found by the studies she surveyed compared with some earlier studies may have reflected the fact that the earlier studies involved participants from community-based, school-based, and other non-employer-based programs, and not just employer-based programs. Comparing the results of these programs with the ones the author surveyed is an “apples–oranges” comparison.
One of the most important financial decisions an American needs to make is when to claim Social Security. The timing of the claim for the retirement benefit has received a lot of attention recently, but the timing of the claim for survivor benefits is also very important, particularly given the loss of income that can occur on the death of the first spouse. In “Social Security Claiming Strategies for Widows and Widowers,” Bill Reichenstein and William Meyer offer a guide to the perplexed. They zero in on the complication posed by the fact that the survivor can choose between a survivor benefit and a retirement benefit based on his or her own work record.
The authors present the simplest case, which occurs when the survivor has reached the age of 70 and has not yet claimed her own benefit. The correct strategy at this point is to claim the higher of the full widow’s benefit, whose derivation the authors explain, and the survivor’s own retirement benefit. Further delay does not change either figure.
In general however, the correct strategy depends on the ages of the deceased and surviving spouse, as well as the deceased’s principal insurance amount (PIA)—the retirement benefit the deceased would have received had he or she lived to the full retirement age—and the survivor’s retirement benefit. The key to understanding what the correct strategy is for a survivor’s given circumstances is to understand that the survivor benefit increases over the range of 60–66 years when the claim is delayed, while the value of the retirement benefit can be increased by delayed claiming over the range of 62–70 years.
It is possible to switch between the survivor benefit and the retirement benefit, and the authors demonstrate that it can often make sense to claim the survivor benefit first and then switch to the retirement benefit. For example, at age 66 a widow might be entitled to a survivor benefit of $2,200 and a retirement benefit of $2,000. If she elects the survivor benefit of $2,200 at age 66, she can switch to the retirement benefit at age 70, by which age it will have grown to about $2,640. Choosing the retirement benefit instead at age 66 would result in more income, but only for a few years. Assuming the survivor lives into her mid to late 70s, if not longer, she is better off electing the first strategy. This example gives only the flavor of the analysis of this detailed and exhaustive study, which should be of great value to advisors with older clients and perhaps even some of their clients.
Writing on the vast issue of retirement security has almost always concerned itself with employees, rather than those Americans who own and operate their own business. It is easy to overlook the fact that over 20 million Americans are small-business owners, for whom preparation for retirement must take account of the special role played by the capital invested in the business.
In “The Retirement Preparedness of the Business Owner,” Nancy Forster-Holt sets out a comprehensive analysis of the challenges the small business owner faces in preparing for retirement. She contends that the metaphor of the three-legged stool (Social Security, employer-provided retirement plans, and personal savings) is less well suited for the self-employed than it is for employees. In particular, the retirement dates of the former group can vary more than the latter, and the self-employed have more latitude in making Social Security contributions. The big difference, however, is the role of business capital as an asset that can finance retirement.
The Small Business Administration defines a small business as one having less than 500 employees. The author uses data from the Federal Reserve’s 2013 Survey of Consumer Finances, splitting the self-employed represented in the survey into two groups: the “smaller-small” businesses, with an estimated sales price less than $250,000, and medium-small businesses, with an estimated sales price greater than $250,000. These groups are compared with each other, and with employees. The exercise shows that there are significant differences in attitudes toward retirement, such as the subjectively estimated preparedness for retirement and the expected retirement date between employees and the self-employed, but also between small and medium-sized businesses. In particular, while about one in five employees say they will never retire, two out of five small-business owners express that sentiment, and medium-small business owners are more likely to say they will never retire than smaller-small business owners. Employees rate their preparedness for retirement higher than business owners do, but medium-small owners are less confident in this respect than smaller-small owners, and expect to retire at a later date.
The author also argues that small businesses tend to suffer from what she terms income and wealth vulnerabilities, or an excessive dependence on income from the business and a concentration of wealth in the business. In addition, income fluctuations from one year to the next reduce the predictability of Social Security retirement benefits. Small-business owners are less likely to have pension plans and more likely to invest their financial assets conservatively. A further difference between the two business size classes is that it is more realistic for the medium-small business to assume that the business can be sold, although there is inevitable uncertainty about both the timing and the price. These differences are illustrated by an engaging comparison of two photography businesses listed on the bizbuysell.com website.
On the basis of her research, Prof. Forster-Holt recommends that business owners should make preparation for business exit and retirement a priority. Retirement advisors should be engaged early. In addition, policymakers need to be well informed about the special needs of small-business owners. She also suggests that it would be good if financial institutions could take additional modest risks to finance business transfers.
Finally, Christian Weller has recently written a book entitled Retirement on the Rocks: Why Americans Can’t Get Ahead and How New Savings Policies Can Help, in which he makes the case that perhaps half of America’s working population is headed for a straitened retirement. His book sets out the evidence for this conclusion and proposes a set of measures that will mitigate what he believes to be a very serious situation. Interested readers may consult my review.
TOPICS: Retirement, legal/regulatory/public policy, social security
George A. (Sandy) Mackenzie
Editor
Footnotes
Publisher’s Note
Institutional Investor, the publisher of The Journal of Retirement, wants to extend a special thank you to Bank of America Merrill Lynch for its support of The Journal of Retirement. Please note that no sponsor has influence on the editorial content found in The Journal of Retirement. Representatives from any firm are encouraged to submit an article to our independent Editor, Sandy Mackenzie, for review and prospective acceptance into the publication. All editorial submissions, acceptance, and revisions are the sole decision of Mr. Mackenzie. The editorial submission guidelines are found on the last page of the publication and online at www.iijor.com. Thank you, and I hope you enjoy this and future issues of The Journal of Retirement.
Dave Blide
Publisher, Institutional Investor Journals, dblide{at}iijournals.com
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